Disquieting trend in investment

For a country with a robust record of growth in recent years, recent trends point to a disquieting trend in investment—an important driver of growth. The gross fixed capital formation in the economy barely grew at 0.4% year-on-year, adding very little—0.13 percentage point—to the 7.5% real gross domestic product (GDP) growth in the last quarter of 2010-11. The failure of investment to get a firm grip is disturbing; especially as consumer spending is hit by higher food and fuel costs. To accelerate growth sustainably, India needs higher investment rates of the kind that drove the 8.8% growth averaged annually in 2003-07. Can investment return to that path soon?

Past data of over two decades show that investment typically takes about two-three years to revert to trend. But the pattern from 2000 onwards is more illuminating due to the shift to a higher growth trajectory on the back of strong investment in 2003-07; as a result, India’s economic structure diversified towards investment and exports with falling share of consumption. The surge that lifted India’s investment rates from 27.4% to 39% in just four years was driven singularly by manufacturing, which contributed more than half of this increase in aggregate investment, thereby equalling its share in overall investment—about 42%—with that of the services sector. This raised aspirations that India could soon match Chinese levels of investment to maintain growth rates of 8.5% or more.

The external environment was critical to the 17% average annual growth of real private investment in this period. Manufacturing investment correlates very strongly with exports (see chart), whose growth averaged 25% annually during the global boom. From this standpoint, the recent resurgence of exports should stimulate investment; perhaps the upturn observed from the sequential momentum in investment in the recent output data might be a harbinger.

However, it is confidence in future growth that is the single-most important determinant of investment. Unfortunately, slowing demand in the US, Europe and now, even fast-growing Asia, counters the optimism brewed by recovering exports. And if that isn’t bad enough, oil and commodity prices are supercharged once again; these costs far outweigh interest rates in influencing investment decisions. This is easily substantiated by the consistent fall in the share of projects under implementation in manufacturing since 2007-08—in line with accelerating oil and commodity prices and despite the extraordinary monetary easing since.

If confidence is not forthcoming from abroad, can domestic demand bring about the required dynamism?

Indeed, that was the idea underpinning the expansionary policies following the crisis. But as the chart shows, the correlation between fixed assets’ creation—the aggregate measure of capacity addition, or how much the domestic production base expanded—and exports has held throughout this while. In other words, the post-crisis economic structure has diversified away from investment and exports to rest excessively upon consumption and imports.

So perhaps the correct question to ask is: why is domestic demand not stimulating investment?

One reason why the stimulus failed to boost capital formation is exchange rate appreciation. The resulting competitive pressures upon domestic manufacturers dissuade industrial investments and offset any gains from lowered input prices. Consider that India has become a net importer of steel in the last two years, with an expected 43% increase in imports in 2011-12. Recently, Sonal Varma of Nomura noted that import substitution has accelerated in recent years; imports are “…replacing domestic capacity even in segments where capacity can be augmented, viz. metals, project goods, chemicals, wood products and textiles…although cases like coal and oil can be explained by resource constraints”. Anecdotal evidence of a deluge of cheap Chinese manufactures in Indian markets abounds.

On the other hand, a stronger currency has facilitated the export of Indian demand abroad. Consumers— also benefiting from expansionary policies—gain from cheaper imported goods; additional import demand gets created, too, further fuelling consumption.

The appreciating currency-higher interest rates combination is also an incentive, among others, for outward investments by domestic firms that are set to match inward foreign direct investments (FDI), which have dropped precipitously. India was the sole global outlier seeing a drop in FDI inflows, while these resumed everywhere else in 2010. Further, FDI flows are dominating the non-traded—or less productive—segments of the economy, viz. housing and construction. The percentage share of these sectors in overall FDI inflows jumped from 3.4% (2005-06) to more than one-fifth share (22.2%) in 2009-10. Undoubtedly, the relatively higher inflation rates seen in these sectors—in part, the influence of capital flows and excess liquidity upon property prices—are diverting resources from economic segments rendered less competitive as a result.

The net result is, of course, a widening of the imbalances in the last two-three years: widening current account deficit reflecting a lowered savings rate and a high import bill; rapid rise in short-term debt—more than 10 percentage points since 2008— though low relative to output base; inflation high and well entrenched; and a budget deficit above 4.6% of GDP. The price to pay for expansionary policies.

Unfortunately, India’s macro policies have been starting to look a bit shaky. Might these be consolidated to rebalance towards investment?

Renu Kohli is consultant professor, Icrier, and a former staff member at the International Monetary Fund and the Reserve Bank of India